Firm Uncertainty Cycles and the Propagation of Nominal Shocks

Firms operate in constantly changing and uncertain environments. We argue that firm uncertainty is a key determinant of pricing decisions, and that it affects the propagation of nominal shocks in the economy. For this purpose, we develop a price-setting model with menu costs and imperfect information about idiosyncratic productivity. Uncertainty arises from firms' inability to distinguish between permanent and transitory productivity changes. Upon the arrival of a productivity shock, a firm's uncertainty spikes up as she ignores what type of shock she has received; then uncertainty fades in light of new information until the next shock arrives. These idiosyncratic uncertainty cycles, when paired with menu costs, generate endogenous price flexibility that correlates positively with uncertainty. High uncertainty firms are more responsive to changes in their environment and have more flexible prices, compared to low uncertainty firms. When heterogeneity in firm uncertainty is disciplined with micro-price statistics, aggregate nominal shocks have very persistent effects on output.